Sadie Keljikian, Express Trade Capital
What is purchase order financing?
Purchase order financing is a trade finance solution designed to help businesses finance the production and shipping costs required to fulfill their customers’ purchase orders. This allows companies, typically wholesalers who import or export goods, to grow without selling equity or exhaustively increasing their bank lines.
In a purchase order financing arrangement, a financial institution pays for the cost of goods and shipping (or a substantial portion of that cost). Effectively, the payment is then a loan. Although a purchase order is not an asset, purchase order funders use creative means to secure their loan: in addition to filing a blanket lien on the borrower company, funders collateralize their loan with inventory which corresponds directly with the goods being provided by the supplier (and purchased by the financier on behalf of their client).
Why not just take out a traditional loan?
While purchase order financing, often called PO funding, is a remarkably useful tool for importers, exporters, and wholesalers across industries, it is also one of the least understood varieties of trade finance. As a result, businesses often don’t know it even exists and therefore miss the opportunity to fund their operations and maintain sufficient cash flow without accruing considerable debt. They usually agree to burdensome loan obligations, or relinquishing equity instead.
Many companies sign up for products that have a strong online presence or are otherwise easy to understand but are not ideal solutions. For example, SBA loans are very popular and inexpensive but they are also typically small, inflexible and take many months to get approved, whereas PO funding has none of those roadblocks. Alternatively, a lot of companies also take on high interest merchant cash advance loans (or MCAs) because they have invested a lot in marketing. MCAs are easy to understand, have quick and easy application processes and they employ aggressive sales tactics. However, PO funding offers more flexibility and greater loan amounts at a fraction of the cost.
Is purchase order financing right for me?
PO funding is helpful for companies who need capital to keep pace with their rapid growth or whose credit histories are insufficient to obtain traditional bank lines for operational capital. Unlike banks and traditional lenders, the purchase order funder underwrites the transaction rather than the credit of the business seeking the loan. Therefore, PO funders look to the credit of the final customer (usually a retailer) in addition to that of the wholesaler. By underwriting the transaction, the PO funder is free to look at the underlying purchase order and overall transaction structure rather than solely looking to the financials of the borrower.
In general, PO financing best suits suppliers with at least a few customers who place large orders. Having big-box customers is advantageous because they often have good credit, so your funding requests are more likely to be approved and financing costs will probably be lower.
Aside from credit requirements, purchase order funders look at many other aspects of the transaction. Purchase orders should have a minimum profit margin of 20% to provide enough cushion to cover the extra cost of PO funding. Purchase orders should also be non-cancelable. Due to wishful thinking or simple oversight, companies often overlook contingencies in purchase orders and might not realize that an order is actually on consignment, which allows the customer to return whatever goods do not sell. The purchase order can also call for partial consignment, unreasonably long terms, or any number of other onerous terms and conditions. PO funders are adept at reading purchase orders and helping their clients understand and structure their transactions more efficiently.
How are PO financing rates determined?
PO financing rates are proportionally based on utilized funds, meaning the amount that the finance company pays to the client’s supplier. Once the lender confirms the utilized funds, they use the supplier and the customer’s credit to determine risk. Like most traditional loan agreements, the bigger the volume, the lower the rates. Also, the greater the risk, the higher the rates.
Purchase order financing rates vary between lenders and locations, but on average, they are determined using a similar formula:
(a) Deal Fee – The funder will charge a “deal fee” or “facility fee” to do the transaction. The fee is usually 1-3% of the loan amount requested and covers service costs (i.e. processing and administrative costs).
(b) Interest – PO funders will then charge interest on the loan amount until the client pays it back. A typical PO funding interest rate is 2-3% for the first 30 days, and around 1% per 10 days after the initial 30. This is subject to change based on the creditworthiness of the client and/or that of their customer, and the risk involved in any given transaction.
How does PO funding relate to factoring?
While factoring and PO funding are different varieties of lending, they often work in tandem. When a wholesaler enters an ongoing factoring agreement, they receive funding against their invoices, which retailers repay (barring any issues). When factoring and PO funding are utilized in conjunction, funds lent against purchase orders can translate to an advance (or portion thereof) against invoices. In other words, the wholesaler no longer needs to repay the financial institution that provided funding against their purchase orders. The financial institution is then reimbursed when they collect from customers on the factored invoices.
How do I start?
If you plan to seek funding against your purchase orders, prepare yourself as best you can. Investigate your customers’ creditworthiness to whatever extent you can. If you and your customers have good credit, your lender will most likely approve your request and offer you competitive rates.
At the end of the day, the specific details of purchase order financing agreements vary from lender to lender and from one client to the next. Risk analysis is not an exact science, but if you find yourself short on operational funds and have reliable, creditworthy customers, purchase order financing can simplify your sales process and day-to-day finances significantly.
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